LIBOR is the most important price in the world of finance – and hence affects us all.
Before ‘Humpty fell off the wall’ our understanding of the ‘Cost of Funds’ was usually the Bank of Englands’ Base Rate. Most business loans and overdrafts were priced as ‘X% over base’. Base Rate has for some time however no longer been the true cost of funds for a bank, as it represents the price that the Bank of England would lend to a bank ‘as a last resort’. That is not however how the banks borrow – they actually borrow from each other using surpluses in the market. The rate they pay is the London Inter-bank Offered Rate – with rates typically quoted for 3 and 6 months loans.
LIBOR will have always been used for large ticket loans to businesses, but now that there is such a differential between Base Rate and LIBOR the banks have no choice but to use it as the starting point for pricing most business loans.
So who sets the LIBOR rate? Given its importance the process for arriving at LIBOR might be seen as a bit old-fashioned. Hard data on actual rates is apparently not available, so the BBA (who are responsible for setting the rate) asks 20 banks, each day, what they feel they should pay to borrow – almost a ‘best guess’. The answers are ranked and the top and bottom 25% are ignored (to avoid extremes). the remainder are then averaged to arrive at the rate for the day, for 15 different borrowing maturities in ten different currencies.
This has created claims that a number of banks could have co-operated to influence LIBOR and a pending Court Case in the US will prove critical. The reason this case has been brought is that a significant loss has arisen for an organisation as a result of the pricing of a Treasury product which has gone against the borrower. The claim is that the price was artificially and criminally distorted.
The implications could be huge, given that LIBOR is used to price mortgages, personal loans and how returns are calculated for pensions and other investments.
Reform is therefore likely, using hard data on actual transactions undertaken.
Meanwhile expect to see more of LIBOR as the current base rate of 0.5% continues to be an almost irrelevant measure for banks and borrowers.